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Finding a good tax shelter

One of my columns was about someone still working after having reached his “full retirement age.” Full retirement age, in Social Security speak, is that time in your life when you are eligible to collect your “full retirement benefit” without any offsets while maintaining a full-time job.

For those born between 1943 and 1954, the full retirement age is 66. So, although up to 85 percent of his Social Security benefit can be taxed, he avoided the tax by contributing his entire Social Security benefit into his company’s 401(k). The icing on the cake was the 3 percent match made by his employer that also went into the plan and was not taxable to him. Needless to say, he was a happy camper.

With all the brouhaha generated by the deficit ceiling “crises” looming in a few weeks, there is some interesting information regarding government tax and spending.

Below is a shortened version of the 2011 “Index of Economic Freedom” published by The Heritage Foundation and the Wall Street Journal that shows government tax and spending.:

United States: Tax burden percentage of GDP is 26.9 percent; government expenditure percentage of GDP is 38.9 percent.

“Gimme Shelter” was the opening track of the Rolling Stones 1969 album, Let It Bleed. And the “Taxman” was written by George Harrison for the Revolver album when he discovered that Harold Wilson’s Labour government established a 95 percent super tax in 1966 and that the Beatles would be subject to the tax.

Obviously, we all need some shelter from the taxman!

Here’s how another client did it: A gentleman was referred to me towards the end of 2010. He was in his late 50s and had enjoyed a successful business career. He came to see me because he’d retired and wanted to put the various pieces of the puzzle together. Having spent most of his time on his career and his family, he hadn’t gotten around to some of the tenants of financial planning such as tax and cash flow planning, investment planning, retirement, risk management and estate planning. This is not unusual as one has only so much energy, time and focus.

In our initial conversation, he mentioned that he’d earned about $100,000 as a consultant in 2010. A light bulb went off in my head (of course it was a government compliant CFL compact fluorescent lamp and not one of those evil incandescent bulbs), so I asked him, “Do you need the $100,000 to live on?” His answer was, “No.” I responded, “Would you like to stash a chunk of it away in a retirement plan?” His answer was a resounding, “Yes.”

It was near the end of the year, so we had to get the document signed to establish the plan before Dec. 31. Funding for the plan could wait until April 15, 2011 or, if he filed an extension, until the date of the extension. Funding was not a problem for him because his portfolio was large and liquid.

I immediately contacted Charles Rosenberg, a principal at INTAC Actuarial Services here in Ridgewood, to determine the best plan for my new client and to get everything done by the required year-end deadline. To use the jargon of the industry, we set up a Solo 401(k). Solo or individual 401(k) plans came from the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) signed into law in 2001. This legislation enabled and encouraged selfemployed people to enjoy the advantages of 401(k) plans without the administrative costs and burdens that typically accompany 401(k) plans.

So, without a lot of administrative headaches and government red tape, my new client was able to contribute $22,000 as an employee and $20,000 as an employer for a total of $42,000. Although his taxable income was $100,000, after the 401(k) contribution, it was reduced to $58,000. The money can be invested in a myriad of investments, and it will grow tax-deferred until it is withdrawn. If he continues to work as a consultant, he can continue to make contributions in the future, but what if he doesn’t.

Let’s say, hypothetically, that the $42,000 contribution compounds at 7 percent. In five years, it will be worth $58,907. In 10 years, when he is in his late 60’s, it will be worth $82,620. In 12 years, it will be worth $94,592, and because he will be 70 1/2 years old, he will have to take a required minimum distribution RMD. That amount is $3,452. Big deal.

If he dies before his wife, he can pass this along with his other IRAs to her and she can treat them as her own. Then his wife can pass them on to their children who can hold them as beneficiary IRAs and take out withdrawals based on their life expectancies.

This was the first step in his financial plan because it had a deadline. There will be many more.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual.

Randy Neumann CFP (R) is a registered representative with securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Ave., Upper Saddle River 201-291-9000.

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